Iraq Concerns Continue to Overshadow
Economics

By

Jennifer Ablan

Updated Feb. 3, 2003 12:01 am ET / Original Sept. 15, 2019 6:13 am ET

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IN A WEEK that President Bush pushed his economic stimulus program and the Federal Reserve maintained its low interest rates to nurture the sluggish expansion, these key economic factors again were overshadowed by the growing likelihood that Iraq will be disarmed by force.

The tone was set last Monday, when Hans Blix, the chief United Nations arms inspector, told the Security Council that Iraq had not cooperated fully with inspectors. President Bush's forceful defense of his stance in his State of the Union address Tuesday and in a joint appearance with British Prime Minister Tony Blair on Friday, as well as in a letter by Britain, Italy, Spain and five others published in the Wall Street Journal in support of disarming Saddam Hussein added to growing opinion that military intervention was almost inevitable.

That realization is "freezing investment activity and adversely impacting business planners," to a great extent, observes William Sullivan, senior economist at Morgan Stanley.

This week, investors are bracing for more of the same. Secretary of State Colin Powell will present new intelligence to the Security Council on Wednesday, which the Administration says will prove Iraq is hiding weapons of mass destruction and has ties to terrorist groups. Key economic reports, including the January Institute of Supply Management report out Monday and last month's employment data due Friday, are likely to cede center stage to the Iraq situation.

Treasuries had a volatile week, rallying Thursday after Bush stepped up his rhetoric against Iraq and as the stock market extended its slide, in part in reaction to news that
AOL Time Warner
posted a 2002 loss of nearly $100 billion -- the largest in U.S. corporate history. But a rebound in stocks Friday and a deluge of new Treasury supply slated to be announced this week had the market retracing most of its moves.

The yield on the two-year Treasury note, the maturity most sensitive to expected Fed moves, fell to 1.67% on Friday from its when-issued yield of 1.70% one week earlier, as the Treasury auctioned a record-matching $27 billion of two-year notes. The yield on the benchmark 10-year note also rose to 3.97% from 3.93%, while the 30-year bond's yield edged down to 4.84% from 4.86%.

As expected, the Federal Open Market Committee Wednesday unanimously voted to maintain its federal-funds rate target of 1.25% and its "neutral" policy bias. The policy-setting panel has held that stance since its November meeting, when it cut the funds target a half percentage point. The thinking has been that the Fed was likely done easing for the cycle.

But Morgan Stanley's Sullivan posits that if financial conditions tighten as they did last summer, particularly amid a pending war, "that would weigh negatively on economic potential and that in effect would trigger an ease" by the Fed.

Fed officials are paying close attention to financial-market conditions. Minutes of the Dec. 10 FOMC meeting released Thursday, noted: "The general calming of financial markets was reflected in some decline in risk spreads from very high levels and sizable new issuance in private bond markets; in equity markets, issuance had edged up and stock prices, though recently declining somewhat, were still well above the lows of early October." In other words, financial market conditions had eased.

Indeed, any increase in volatility in corporate bonds now would reflect a war-risk premium instead of individual company events, says David Goldman, head of the global markets group research of Banc of America Securities. Last year, the market was rattled by the corporate malfeasance of Enron, WorldCom and the like.

In one example,
Sprint
's 8.375% notes due 2012 fell initially nearly 10 points, or $100 per $1,000 bond, last week following reports that company chief executive William Esrey and president Ronald LeMay were stepping down ahead of this week's earnings report. (Sprint declined to comment on the reports.) But the bonds subsequently recouped those losses -- a sharp contrast to the likely meltdown that probably would have taken place a year ago.

In a further sign of the capital market's vigor, 27 investment-grade corporate bond issues totaling $11.1 billion and four junk-rated issues totaling nearly $1 billion were priced last week.

Money managers agree that the financial markets look healthy.

Ian MacKinnon, managing director and head of fixed income for The Vanguard Group, who oversees about $235 billion, says another rate cut by the Fed is not "warranted" nor would it be "productive." Further easing is not likely to stimulate incremental borrowing or spur capital spending, the weakness of which has dampened economic growth for more than a year.

But others voice concerns whether consumers -- who have been the stalwarts of the halting, recovery owing in large part to massive mortgage refinancing -- will be able to continue to play that role until business spending picks up meaningfully.

"What happens if the stimulus to the consumer brought on by lower interest rates exhausts itself prior to a rise in business spending brought on by resolution to geopolitical risks?" wonders Marc Seidner, director of domestic taxable fixed income at Standish Mellon Asset Management.

"At this juncture, it would serve the Fed well to manage interest-rate expectations lower to ensure that the consumer has the staying power to bridge the gap."

But while those issues continue to spook the financial markets, it hasn't exactly been doom and gloom for capital spending. Economic growth slowed to a 0.7% annual pace in last year's fourth quarter, as consumers sharply cut their spending on durable goods such as autos after splurging in the preceding quarter.

But businesses loosened their pursestrings to post their first increase in spending on equipment and software in two years. Overall, business fixed investment, which also includes spending on commercial construction, rose at a 1.5% annual rate in the fourth quarter, led by a 5% increase in spending on equipment and software. Weakness in this category has been the signal aspect of this cycle, unlike previous ones, which typically have been led by consumer and housing spending.

"The scene is set for a rebound in corporate spending when current uncertainties diminish," writes Martin Barnes, managing editor of the Bank Credit Analyst, in a recent report. Having said that, says Barnes, "The longer the war uncertainty drags on, the longer it will be before companies abandon their retrenchment mindset, and the greater the risk that consumers may also start to cut back on their spending."

While capital spending is showing signs of life, companies have been restraining expenditures to maximize free cash flow and bolster their debt-laden balance sheets. The parlous financial state of Corporate America is evident in a Merrill Lynch report showing that 45% of all investment-grade U.S. corporate bonds fall into the triple-B rating range, just one level above junk. That is the highest percentage since 1988, according to Merrill.

The FOMC has taken notice as well.

"Many business firms had continued to enhance their prospects for rising profits through productivity improvements and debt restructurings that were strengthening their balance sheets and liquidity," according to the FOMC's Dec. 10 minutes. "Concurrently, indicators of credit quality in the household sector appeared to have remained essentially stable," it added.

That bolsters Vanguard's MacKinnon's view that the Fed does not need to ease any further and that the economy will be stronger than most people expect. As a result, he thinks the central bank will raise its fed-funds target by a half to three-quarters of a percentage point by year-end.

That has him positioning Vanguard's bond portfolios defensively in anticipation of a less positively sloped yield curve. MacKinnon has their durations (a measure of bonds' sensitivity to interest rate changes) a bit shorter than their benchmarks and has been emphasizing corporate bonds in the single-A range.

Iraq Concerns Continue to Overshadow
Economics

IN A WEEK that President Bush pushed his economic stimulus program and the Federal Reserve maintained its low interest rates to nurture the sluggish expansion, these key economic factors again were overshadowed by the growing likelihood that Iraq will be disarmed by force.

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